An Analysis of Yield Curve Notes

ABSTRACT

This paper analyzes a new type of security, the yield curve note, which pays interest at a rate that varies inversely with
short‐term interest rates. A valuation model for yield curve notes is presented, the parameters of the model are estimated
empirically, and the estimated model is used to explore, in simulation, the price behavior and risk characteristics of yield
curve notes in comparison with fixed‐rate notes. The risk of a yield curve note is approximately twice as great as a fixed‐rate
note with the same maturity. The unique risk characteristics of yield curve notes make them useful (as liabilities) in immunization
strategies for financial institutions. Their usefulness in this regard may be the chief rationale for their development.